Should You Be Buying Municipal Bonds Right Now?

The municipal market may soon garner negative headlines if an expected large number of states and municipalities announce budget deficits with the July 1 start of their fiscal year. Municipal bond credit quality may therefore come under question, and investors need to be prepared. Budget strains were expected but are becoming more widespread, and none are more high profile than California’s. Last week, State of California general obligation bonds were placed on credit watch for a potential downgrade by all three major rating agencies, citing the lack of a budget resolution.

Although news of budget strains may peak over the coming weeks, municipal credit quality questions will likely persist for some time.

However, the municipal market has historically held up well in response to credit quality challenges.

Municipal bond investors can take preventative measures but should stay the course and use weakness to add to positions.

The Rockefeller Institute of Government, an independent researcher of state and local governments, reported June 18 that states’ personal income tax collections declined by 26 percent during January to April of 2009 versus the same period in 2008. Among the three sources of state revenues, personal income tax, corporate income tax, and sales tax, personal taxes are typically the biggest share of state revenues. Although states and municipalities do their best to forecast revenue shortfalls, mismatches can occur with budget shortfalls as a result.

Municipal Bond Investors Should Be Cautious

Municipal investors should be aware that budget issues will likely persist for some time due to the lagged way recessions impact state and local budgets. The highest income taxpayers, who contribute most to personal income tax revenue, often derive a substantial portion of their income from capital gains in the stock market. These high-income taxpayers generally make estimated tax payments on a quarterly basis based on the prior year’s tax liability, which is usually determined by April of the current year. So early 2009 payments were based on 2008’s tax liability, and future payments are likely to be ratcheted down as lower income and capital gains are reflected in even lower payments through the remainder of 2009 and into 2010.

State revenues have bottomed on average two years after the start of recession. Since the recession started in 2008, this history suggests state and municipal revenues will continue to be impacted into 2010. According to the Washington D.C. based Center of Budget and Policy Priorities, state budget deficits may collectively accumulate to $370 billion by fiscal year 2010-2011. Fiscal stimulus, which totals $140 billion over three years, is a huge aid but still addresses less than half of states’ needs.

States have already taken steps, with 23 already increasing taxes or fees, and another 13 planning to do so, in addition to cutting expenses: the two traditional steps to balancing budgets. The process can unfortunately be subject to political wrangling, with one side clamoring for higher tax rates and the other for cost cutting. Both views can create negative headlines as politicians stress the negative consequences of each and often wait to the last hour before settling budgets. In the meantime, the resulting uncertainty can lead to weak markets.

However, the municipal market has historically held up well in response to credit quality challenges. We believe that budget strains will result primarily in downgrades and that defaults will be more isolated. Should conditions deteriorate further, however, it is worth noting how well the municipal market has historically withstood such tough times.

Municipal Bonds Resilient

During the Great Depression the default rate increased to 7%, according to a report from the National Bureau of Economic Research (NBER); however, the default rate ultimately amounted to only a 0.5% loss rate for investors as municipalities paid most debt obligations back at full value within 18 months. Hurricane Katrina posed another recent threat as the population of New Orleans fell by almost 50 percent in the year following the hurricane. Despite this reduced tax base, no New Orleans general obligation bond (GO), nor any of the area’s various school district GO bonds, defaulted. Many bonds were downgraded to below investment grade but returned to investment grade status within two years.

The resiliency of municipal bonds was highlighted in a 2007 report by Moody’s Investors Service, which states the 10-year cumulative default rate from 1970 to 2006 for all investment grade municipals averaged only 0.10%. The default rate for bonds rated single-A was 0.03%, less than that of triple-A rated corporate bonds. For those that did default, recovery rates were very high at 90 to 95 cents on the dollar for non-healthcare related bonds. Moody’s was set to upgrade thousands of municipal bonds based on the findings of the report but has postponed such a move due to the recession.

Part of the resiliency of the municipal market can be attributed to the flexibility of issuers, unlike corporate issuers. Many municipalities are monopolies and have great latitude in raising income (by increasing taxes in some cases) and cutting expenses. In the event of default, municipalities cannot simply vanish the way a corporation such as Circuit City might. The municipality and its service obligations to its residents remain, and the municipality is forced to restructure. Since most will have to tap debt markets in the future, treating bondholders as best as is possible is in the municipality’s best interests in order to borrow at an economically feasible rate in the future. In 1994, Orange County, California, the largest municipal bankruptcy on record, was an example of this as all debt obligations, including payments to other municipalities, were paid in full.

What investors can do

It is quite possible that the municipal default rate could surpass that of the Great Depression. Today’s municipal market is different, with more complex bonds which include special purpose financing and corporate backed bonds.

How do investors prepare? First and foremost, investors can stay with high quality bonds rated single-A or higher. This segment of the market has demonstrated minute default rates. Furthermore, by focusing on general obligation and essential service revenue bonds, investors take additional precautionary steps. In California, for example, a bond backed by a water revenue project is likely to retain pricing power and weather the recession better, because water is a scarce commodity in the state. The Moody’s report referenced earlier also highlights a well-known fact in municipal markets;
defaults have been concentrated among healthcare, multi-family housing, and corporate-backed bonds (such as Industrial Development Revenue bonds).

With regard to current markets, municipal bonds are living up to history. The vast majority of defaults so far over 2008 and 2009 have been among low rated (either below investment grade or non-rated) issuers and bonds from housing, healthcare, or corporate backed sectors. The municipal market is already priced for credit deterioration. Although yield differentials, or the spread, between top rated bonds (AAA) and the lowest investment grade rated bonds (BBB) have narrowed over the past few months, they are still almost double the prior peak. A wide yields spread is one reason why we maintain an allocation to Tax-Free High Yield Bonds.

The high quality municipal market has improved a great deal relative to Treasuries in 2009 but remains attractively priced. By simply comparing average AAA-rated municipal yields as a percentage of Treasury yields, we note that average 30-year AAA municipal yields are 117% of comparable Treasuries (i.e., still higher than Treasuries), versus 90% before the credit crunch began in July 2007. The higher this percentage, the cheaper municipal bonds are relative to Treasuries and vice versa. Similarly, average AAA-rated municipal yields are 93% of Treasuries, versus 80% pre-credit crunch.

We do not dismiss credit concerns, as they will be with the municipal market for some time. In our 2009 Outlook Base Case Scenario, we expected municipal valuations to remain cheap to historical norms, and credit quality was one of the reasons why. Credit quality concerns could lead to bouts of weakness. More risk adverse investors can take additional precautions by focusing on higher rated or safer sector issues. Still, we think the market has priced in a buffer via cheap valuations to Treasuries and still wide yield spreads. Given improvements in the national economy over the second quarter, the tide is slowly turning. We would use bouts of weakness to add to municipal positions. Over time, states and municipalities will repair their balance sheets, and the prospect of higher future taxes makes today’s valuations compelling.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.

Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.

GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.

Muni Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply.

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